Market waits for yuan move

Commentary: Is a stronger Chinese currency really a sure thing?

HONG KONG (MarketWatch) -- The yuan is likely to remain in the spotlight this week with expectations Beijing that is ready to raise its rate against the dollar by 2%-3%.

But we are still a long way from a full yuan float, given the uncertainty surrounding how the currency would respond if the capital account was thrown open and investors took a closer look at China's fundamentals. Most likely Beijing is expected to revert to a managed peg. as it had between 2005 and 2008, to allow a small daily movement within a band. Still, this does mean in theory the currency can move in both directions.

China's lurch into a March trade deficit is one reason to take second look at expectations for a stronger yuan. Also in the week ahead, gross domestic product and money-supply figures for the first quarter will be released, providing an update on the economy's health.

The timing of a Beijing currency move as the country's March trade balance swung to a $7.28 billion deficit for the first time in six years certainly appears a strange coincidence. China's exports grew 23.4% from a year earlier but were dwarfed by the huge 66% growth in imports.

Most economists suggest China is still in a secular surplus mode, and in any case, there was a still a trade surplus with the U.S. Nonetheless, these figures would also tally with weak global demand for mainland Chinese exports, coupled with strength in China's domestic economy. One clear example of this is that new car sales grew 76% in the first quarter from a year ago to 3.52 million units. At the very least, these import numbers and the new trade deficit will give pause for thought.

The GDP numbers should give some clarity on the fundamentals behind China's currency -- the economy. Here most analysis goes no further than China's double-digit GDP growth, its seemingly ever-increasing trade surplus, and its $2.4 trillion mountain of foreign-exchange reserves. This explains expectations for a stronger yuan.

Yet these numbers tell us little about the prevailing concerns of equity investors -- structural imbalances in the economy, such as excessive fixed-asset investment, reliance on huge property bubbles and rising inflation. These factors also have the potential to weigh on the yuan, even if it is a managed float.

RBC Capital Markets says in a new report that they expect inflation pressures to pick up in coming months as real interest rates have become increasingly negative. The consumer price index is rising at 2.7% and benchmark deposit rates are at 2.25%. If a small currency revaluation happens, this could be the cue to raise interest rates. Beijing needs to strike a balance, since if inflation did spiral out of control, it could start to debase the currency.

The stock market has so far largely ignored bubble concerns, reflecting optimism that Beijing can somehow manage a property slowdown. Figures from Credit Suisse research, however, show how stretched affordability is in mass-market housing, with mortgage payments taking up to 65%-70% of monthly household income in Shanghai and Beijing, according to its estimates. Here, the market looks exposed if interest rates rise or if there is a slowdown in income growth.

Another consideration that analysts are beginning to dig deeper into is China's true fiscal strength beyond its massive foreign-exchange reserves.

Earlier this year, it was revealed the extent to which the income of local government finances is tied to the property market. Land sales by China's local governments generated 1.59 trillion yuan (around $233 billion) last year, up more than 60% from a year earlier. Following on from this, Credit Suisse estimated the total debt of local government entities will reach 12 trillion yuan by the end of 2010, or one-third of GDP. This makes the property exposure look like small beer.

While these numbers are manageable, says Credit Suisse, any property crash would have potentially far-reaching ramifications.

This is one reason Beijing is likely to proceed with a gradualist approach to currency reform and the capital account. No one expects a full liberalization of the yuan, giving mainlanders the freedom to spend their currency anywhere they please, anytime soon. In the meantime, it's worth watching to see if yuan appreciation is as sure a thing as many expect.

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